Public pension underfunding at the state and local level has rightly received an enormous amount of attention over the past few years. Most public pension funds are significantly underfunded when pension liabilities are valued using economically reasonable assumptions. In fact, Moody’s has calculated total underfunding to be roughly $1.8 trillion as of 2011, meaning the total value of pension fund assets is roughly $1.8 trillion less than the amount these funds owe to current and future retirees. From a municipal bondholder’s perspective, fundamental questions become whether the size of the pension underfunding might impair an issuer’s ability to pay back its bonded debt and exactly how states and municipalities will be able to reduce the amount of underfunding.

While I’d still say we’re in the second inning of a nine-inning game (with this guy pitching), recent developments in Detroit, Illinois and elsewhere are starting to shed some light on potential paths forward. Two of the biggest developments have been 1) the possibility that federal bankruptcy law might supersede state constitutional protections against the impairment of pension benefits and 2) that several states and municipalities (including the state of Illinois) have passed legislation that either partially or fully suspends cost-of-living adjustments on pension payments. While it’s painful to see anyone receive less than what they were expecting, especially since a large portion of the underfunding blame falls on politicians who promised too much and contributed too little to the pension funds, these developments are positive from a municipal bondholder’s perspective.

Why Bondholders Should Care

One of the thorniest aspects of the pension debate is how states could possibly reduce benefits when certain states had explicit constitutional language protecting these benefits from being impaired. Many states interpreted this language to say that these protections extended not only to those already receiving benefits but to any current public employee. Federal Bankruptcy Judge Steven Rhodes, who ruled that Detroit was eligible for federal bankruptcy protection, has now clearly stated that pension benefits could be impaired regardless of state constitutional protections. This viewpoint will no doubt be subject to significant legal challenges, but he becomes the second federal judge that I’m aware of to make this point.

Cost-of-living benefits are commonplace in many public pension arrangements. They can be either fixed in nature (i.e., the pension benefit increases by a fixed percentage each year) or linked to an inflation index like CPI. One might think that suspending this benefit would do little to reduce pension underfunding. However, a quick numerical example shows why this isn’t necessarily true. If I owe someone a fixed amount of $100 in 10 years, today’s value of what I owe is about $74 (anyone interested in the details behind this calculation, let me know). However, if I owe someone $100 in 10 years grown by CPI, today’s value of what I owe is about $93! This is 26 percent more than what I owed in the fixed $100 scenario.

A Word of Caution

As I noted above, it’s still early. Virtually every single change to public pension benefits that I’m aware of has been or is subject to appeal and additional litigation. It could be the case that some of these initial rulings get overturned or reinterpreted. Investors looking for high-quality municipal bond portfolios are wise to continue to focus on high-quality municipal bonds with above-average pension funding.